Story of Squanderville and Thriftville

While browsing the web, I was doing my usual round of picking up investment related stories. I stumbled upon the Berkshire Hathaway site. Anyone who isn't immediately thrown off by the almost lifeless simplicity of this site, would know that this site is a treasure chest of incredible amount of wisdom.

There is an article posted on the web site that I seem to have missed previously. I would like to highlight the following: a Fortune article from Buffett regarding the U.S. Trade Deficit. This article is a must read for anyone interested in macroeconomics, business and investing. In fact, if you have any relation to U.S., then you may find this article interesting.

Buffett describes a story of two islands called Squanderville and Thriftville. As you may have guessed from the names, the people in Squanderville prefer to squander their earnings (food, in this simple scenario) and live beyond their means. People of Thriftville, on the other hand, live well within their means, and do not mind having a surplus of food production. They eventually start trading; and in a matter of years, people of Squanderville realize that they could just offer Squanderbonds to the nation of Thriftville in exchange for food -- and Squandervillites never have to toil in the fields again. The story goes an and morphs into something very intersting.

Buffett, in his usual charming way, completes this story and talks about a way to fix the alarming U.S. trade deficit problem. He describes something called Import Certificates (ICs) that are issued to U.S. exporters.

Complete article: http://www.berkshirehathaway.com/letters/growing.pdf

Intrinsic Value Realized

Mr. Market has been incredibly excitable last week (Sept 15-19, 2008)... near the last couple of days of the week, the Mr. Market has been incredibly exuberant.

One thing I have noticed is that in the wild swings of the market, Mr. Market realized the value of Berkshire Hathaway. It closed the week at $147,000 per share. Notice that the intrinsic value that I calculated was $145,517. Frankly, I never thought that the equity would trade above my intrinsic value calculation so soon. This goes to show the positive side of the wild mood swings of Mr. Market.

Question is, should one sell their Berkshire Hathaway unit(s) to the enthusiastic market? I for one will not, since I will stick to my motto that Berkshire is for life. If I could find an appropriately priced business that can have level of consistent cash flows like Berkshire, or sane management as Berkshire, then I would gladly sell [most of] my Berkshire units (but never all) and buy that business. Alas, there is no such business I know of at this current time. That being said, I am in the long haul with Berkshire -- perhaps one of the finest businesses around.

I expect the price to fluctuate and perhaps go back down to the levels from a week ago. An intelligent investor must not be concerned with the daily fluctuations of equity prices.

Market Commentary for August 2008

Very sensible and clear market commentary has been posted by ABC Funds for the month of August, 2008. I greatly enjoy listening to the monthly commentaries as they put a lot of the market noise into perspective.

Commentary is also available as an mp3. The complete text follows:

Securities trading during the month of August can be characterized by continued extraordinary price volatility as stock prices see-sawed back and forth. Interestingly, the market has weathered considerable negativity over the past month with lingering solvency concerns over the mega U.S. mortgage lenders Fannie May and Freddie Mac as well as the uncertain affairs of Lehman Brothers, U.S. banks, etc. Nonetheless, the market continues to confound investors as frenetic trading volumes and price volatility seem to be masking a resurgent U.S. dollar, relatively low American interest rates, a +3.3% second quarter U.S. GDP growth rate and generally decent corporate profits. For many investors the glass appears to be half empty as rampant negative psychology appears to have permeated the marketplace.

As fundamental analysts and contrarian investors we are starting to uncover an increasing number of significantly undervalued equities. However, largely due to widespread investor fear and a drive toward liquidity these stocks drift even lower despite improving prospects. At times these price declines make little sense. For instance, we offer an example of one of our ABC Funds shareholdings, Jo-Ann Stores. Jo-Ann Stores, the largest U.S. retailer of fabrics, is a solid company with improving sales, financials, and a tangible book value of $18.00. However in the space of several months its share price plunged from $24 last fall to $9.03 on January 16, 2008. We were most perplexed since president and CEO Darrell Webb had been doing an excellent job of running this $2 billion sales company in a very difficult retail environment. Upon deeper analysis we found nothing fundamentally wrong with the company and couldn’t really explain the drastic price decline. Now, seven months later and after two excellent quarterly reports as well as improved operating guidance the shares are trading at over $25. Now, considering the capital appreciation from $9 to $25 the question is: what has changed since the January 2008 $9.03 low? Nothing really. Unfortunately, Jo-Ann Stores is a typical example of the extraordinary trading volatility in the marketplace.

The fact is investors are in a “show me” mode. Furthermore with the incessant concern of “other shoes to drop” in the U.S sub prime mortgage area, many investors, bankers and institutions have become gun-shy. Not helping matters is the considerable speculation on the health of numerous hedge funds in that a number of these capital pools have imploded and are closing shop. This situation, additionally, has enervated the securities markets.

While it may sound trite, the present financial uncertainty, fear and rush toward investment liquidity is producing a growing number of attractive opportunities. The daily price volatility due to investor angst is also providing huge trading swings and excellent investment entry points for those with the necessary stamina and patience. We are constantly surprised how certain dirt-cheap stocks have drifted lower and lower despite improving fundamentals. Overall, it is our belief that negative market psychology has overtaken long term fundamental analysis. This will change.

Once again we believe that the overlooked value market while currently languishing presents excellent, long term value. Many pubic companies continue to trade at significant discounts to their net asset or replacement values. As a result we continue to expect more and more company share buybacks, mergers, acquisitions and takeovers. Although we are not certain what the necessary catalyst will be to spur on a significant upturn in value stocks we remain optimistic and patient. Not unexpectedly, we look to the Jo-Ann Stores example of investment patience producing long term financial rewards.

Thank you,

Irwin A. Michael, CFA

This time it is different (not really)

An intelligent investor studies enough history and understands enough about the economy to know that history does repeat itself. The Economist has written this article to show how it is different this time around -- but as I read this concise and informative article, I am drawn to the fact that things aren't very different after all.

Sure the bear market this time around, got the double shock of commodity prices and credit freeze, but some market fundamentals are still the same. To name a few; human greed, speculative nature of traders, and short term focus are still strong as ever, if not much worse.

As an intelligent investor, it is important to note all these factors and understand them, but not let them directly affect your decision to buy or sell any business. The macro knowledge must only be used as a guide to understand how businesses function and can be affected. An intelligent investor never tries to play the prediction game and place bets on expected the future trends -- no matter how educated those guesses are. There is enough ink spilled daily by various experts who predict the market for a living. If they were always making correct predictions, market would actually be efficient and all securities would always be efficiently priced. Reality is evidence to the contrary.

The only criterion for an investment must be valuation, and nothing else. This must be true at all times -- boom or bust.

Is history repeating itself?

I stumbled upon an excellent article from the August 21 issue of the Economist; comparing the current American crises with the Japanese one in the early 1990s. History does have a tendency of repeating itself, but it never repeats itself exactly. There are always similar patterns of repetition, but there is enough difference to believe that "this time it will be different".

The article presents some points near the end to show how the matters are different between the US of today and Japan of the 90s. However, they didn't mention one aspect -- the culture factor. Japanese culture is quite passive, inwardly focused and insular. It is quite Apollonian in nature, while the American culture is much more Dionysian, at least relatively. Hence, I expect that Americans will do anything and everything possible to not be stuck in a stagflation. It would be completely against their very nature to do so.

Anyway, enjoy the full text article:

AS FALLING house prices and tightening credit squeeze America’s economy, some worry that the country may suffer a decade of stagnation, as Japan did after its bubble burst in the early 1990s. Japan’s property bubble was also fuelled by cheap money and financial liberalisation and—just as in America—most people assumed that property prices could not fall nationally. When they did, borrowers defaulted and banks cut their lending. The result was a decade with average growth of less than 1%.

Most dismiss the idea that America could suffer the same fate as Japan, but some of the differences are overstated. For example, some claim that Japan’s bubble was much bigger than America’s. Yet average house prices nationwide rose by 90% in America between 2000 and 2006, compared with a gain of 51% in Japan between 1985 and early 1991, when Japanese home prices peaked (see left-hand chart). Prices in Japan’s biggest cities rose faster, but nationwide figures matter more when gauging the impact on the economy. Japanese home prices have since fallen by just over 40%. American prices are already down by 20%, and many economists reckon they could fall by another 10% or more.

What about commercial property? Again, average prices rose by less in Japan (80%) than in America (90%) over those same periods. Thus Japan’s property boom was, if anything, smaller than America’s. Japan also had a stockmarket bubble, which burst a year earlier than that in property. This hurt banks, because they counted part of their equity holdings in other firms as capital. But its impact on households was modest, because only 30% of the population held shares, compared with over half of Americans.

Nor were Japanese policymakers any slower than American ones to cut interest rates and loosen fiscal policy after the bubble burst, contrary to popular misconceptions. The Bank of Japan (BoJ) began to lower interest rates in July 1991, soon after property prices began to decline. The discount rate was cut from 6% to 1.75% by the end of 1993. Two years after American house prices started to slide, the Fed funds rate has fallen from 5.25% to 2% (see right-hand chart). A study by America’s Federal Reserve concluded that Japanese interest rates fell more sharply in the early 1990s than required by the “Taylor rule”, which establishes the appropriate rate using the amount of spare capacity and inflation.

Japan also gave its economy a big fiscal boost. The cyclically adjusted budget deficit (which excludes the automatic impact of slower growth on tax revenues) increased by an annual average of 1.8% of GDP in 1992 and 1993—similar to America’s budget boost this year. Japan’s monetary and fiscal stimulus did help to lift the economy. After a recession in 1993-94, GDP was growing at an annual rate of around 2.5% by 1995. But deflation also emerged that year, pushing up real interest rates and increasing the real burden of debt. It was from here on that Japan made its biggest policy mistakes. In 1997 the government raised its consumption tax to try to slim its budget deficit. And with interest rates close to zero, the BoJ insisted that there was nothing more it could do. Only much later did it start to print lots of money.

America’s inflation rate of above 5% is an advantage. Not only are real interest rates negative, but inflation is also helping to bring the housing market back to fair value with a smaller fall in prices than otherwise. But in another way America is more exposed than Japan was. When its bubble burst in 1991, Japan’s households saved 15% of their income. By 2001 saving had fallen to 5%, which helped to prop up consumer spending. America’s saving rate of close to zero leaves no such cushion.

The perils of procrastination

John Makin, at the American Enterprise Institute, a think-tank, argues that monetary and fiscal relief were necessary but not sufficient to revive Japan’s economy. The missing ingredient was a clean-up of the banking system, on which Japanese firms were more dependent than their American counterparts. Japanese banks hid their bad loans beneath opaque corporate structures, and curtailed new lending to profitable businesses. A vicious circle developed, whereby banks’ bad loans depressed growth which then created more bad loans.

In another new report Richard Jerram, at Macquarie Securities, concludes that America “will not come close to repeating the experience of Japan”, because its regulatory system, financial markets and political structure will not let it procrastinate for so long. America has a more transparent regulatory structure which presses banks into recognising losses and repairing their balance-sheets—even if regulators were slow to recognise that the banks were shifting risky securitised assets off their balance-sheets in the first place. But Japan’s regulators for a long while were in cahoots with banks over hiding their bad loans.

Over the past year, American banks have been quicker than those in Japan in the 1990s to disclose and write off losses and raise new capital. In Japan it took a long while before the political will was there to use taxpayers’ money to plug the banking system. A big test for America’s Treasury will be how quickly it recognises the need to nationalise Fannie Mae and Freddie Mac, the teetering mortgage giants.

One advantage over Japan, says Mr Jerram, is that America is spreading the costs of its housing bust across other countries. Foreigners hold a large slice of American mortgage-backed securities. Sovereign-wealth funds have provided new capital for American banks. And America’s booming exports have helped to support its economy, thanks to the cheap dollar. In contrast, the yen’s sharp appreciation after Japan’s bubble burst hurt exports at the same time as domestic demand was being squeezed.

By learning from Japan’s mistakes, America can avoid a dismal decade. However, it would be arrogant for those in Washington, DC, to assume that Japan’s troubles simply reflected its macroeconomic incompetence. Experience in other countries shows that serious asset-price busts often lead to economic downturns lasting several years. Only a wild optimist would believe that the worst is over in America.

Source: The Economist

More thoughts on this article have been published by another contrarian (intelligent) investor.

More thoughts on Berkshire

An otherwise noise and speculation filled business media interview, this video presents some very good points why Berkshire Hathaway is a good buy in these times.

Feel free to skip the video to the 21:00 minute mark, and listen to Weitz talk about his views on Berkshire as a long term investment. I had never heard of Weitz before watching this video, but he seems like a very humble and confident investor.